Seigniorage and Fixed Exchange Rates: An Optimal Inflation Tax Analysis

A country that decides to fix its exchange rate thereby gives up control over its own inflation rate and the determination of the revenue received from seigniorage. If the country goes further and uses a foreign money, it loses all seigniorage. This paper uses an optimal inflation tax approach to analyze the consequences for optimal rates of income taxation and welfare of the alternative exchange rate and monetary arrangements. From the viewpoint of seigniorage, a system in which the country is free to determine its own rates of inflation is optimal; fixed exchange rates are second best, and the use of a foreign money is worse. The paper notes that seigniorage is only one of the factors determining the choice of optimal exchange rate regime, but also points out that rates of seigniorage collection are high, typically accounting for five or more percent of government revenue.